Financial markets 2017: Make P/E ratios great again

In a year of intense focus on walls, audio recordings and deleted emails, what is surprising is how little the financial markets have reacted. Compare the U.S. financial markets to the market for the Mexican peso, which has fluctuated based on bets of whether Trump would win. Since May, the peso depreciated by about 15 percent, rebounded 7 percent when the Hollywood Access tape of Trump was released, and jumped to a 20 percent decline following the election.

In contrast, the U.S. financial markets have not reacted much. Last year, we predicted the market would grow “below average,” and we were unfortunately correct. The return of the S&P 500 from November 2015 to November 2016 is about 3 percent, most of which is after the election. This is certainly below the long-term average of about 8 percent, not to mention the high returns we had from 2012 to 2014 (the market grew 16 percent in 2012, 32 percent in 2013 and 14 percent in 2014—for a remarkable total of 75 percent).

Opinions are split on why the market has had a flat response to the political campaigns and a positive response after the election. (The 7 percent fall on election night was in the overnight futures market, which is not very liquid. Jim Cramer said it was “some guys trading in their pajamas.”) Some argue that the market expected Hillary Clinton to win and to continue the current policies. Others argue that with Trump winning, he doesn’t really mean what he says—except maybe on taxes. Still others argue that neither Clinton nor Trump would have been able to implement their agendas because the Congress would be split, and Republicans in Congress have a very different policy agenda than Trump.

Our view is a bit of an outlier: We think the market treated both campaigns as if they were sales pitches that neither candidate believed nor would implement. What really matters is cash flows and valuation—which is what we mean by “let’s make P/E ratios great again.”

Factset examined the recent “earnings calls” of 386 S&P 500 firms between September 15 and November 2, and 80 firms mentioned the word “election.” So only 21 percent were concerned enough about the election to even mention the word. In 2012, it was 26 percent.

For certain, the agendas that appeal to the base supporters of each party if fully implemented would not be good for the stock market. The Democratic agenda of higher taxes and regulation to ostensibly help the middle class will discourage business investment and startups. The Trump agenda of sharp restrictions on trade and immigration will likely hurt much more than a tax decrease will help—especially if he sparks a trade war—and his tax decrease will adversely impact both the budget deficit and the debt level. In either case, any significant policy changes would go through a lengthy legislative process, so implementation would likely start in 2018.

What about 2017?

Fed policy: While we were supportive of the Fed’s liquidity policies during the financial crisis, we are concerned that the aggressive monetary policies since 2009 have become counterproductive and pose a material risk to our investment portfolios.

From 1947 until 2009, GDP growth averaged 3.2 percent per year; since 2009, it has fallen to 2 percent per year. This lower growth is reflected in lower corporate earnings. Over the past two years, S&P 500 earnings, excluding energy, are less than half their historical average. This is no doubt a reaction to what has been the weakest post-recession recovery of the modern era.

The Federal Reserve recently has kept interest rates flat, a “dovish” policy in targeting interest rates rather than inflation in the near term. We expect a small increase in the federal funds rate in December and then one or two small increases next year. This may cause some volatility in the stock market.

International trade: The S&P 500 derives about 31 percent of its revenue from sales outside the United States, so earnings are sensitive to growth in the global economy.

• The eurozone stagnation suggests that the eurozone will not be a source of growth in the U.S. and is unlikely to contribute to major stock market performance.
• China is slowing and transitioning to more of a consumer economy. It will not be as important a source of U.S. manufacturing cost-savings and could see more exports.

With this as a background, we turn to fundamentals. Stock prices are determined by the future stream of cash flows—driven by earnings—and the valuation of these cash flows, which is the present value using a discount rate that reflects risk. Typically, this is summarized by earning forecasts and a valuation ratio—the price-earnings (P/E) ratio.

Fundamentals

There are some positive factors for stock returns in 2017:

• Earnings growth: Analysts are forecasting earnings will increase about 11.6  percent in 2017 for the S&P 500. Energy is predicted to grow 325 percent (that’s not a typo). Real estate is expected to fall 18.6 percent.

• Revenue growth: Among S&P 500 firms, revenues are expected to rise 5.9 percent in 2017. The best sector, energy, is expected to rise 27.5 percent, while the worst sector, telecom, is predicted to rise 1.4 percent. Real estate revenue is expected to rise 5.3 percent.

• Year-over-year earnings growth: For the first time since the first quarter of 2015, this is a positive 0.5 percent for the S&P 500.
• Year-over-year revenue growth: For the first time since the fourth quarter of 2014, this is a positive 2.6 percent for the S&P 500.
• Third-quarter earnings and revenue “beats:” Of the 425 companies in the S&P 500 that have reported earnings and revenues for the third quarter of 2016, 71 percent have reported earnings above the mean estimate of analysts (higher than the historical average of 67 percent) and 54 percent have reported revenues above the mean estimate (matching the historical average).
• Valuation: P/E ratios are above their long-run averages, but only by modest amounts. The S&P 500 P/E ratio is 18, above its long-term average of 15.9. The “forward” P/E (price today divided by expected earnings) is 16.4, above its long-term (10-year) average of 14.3. All this suggests that valuation ratios are not about to fall off a cliff.
• We think inflation will remain subdued. Our forecast of 2 percent is in-line with most forecasts (the Fed’s forecast is 1.5 percent, the Office of Management and Budget’s is 2.2 percent, and the Organization for Economic Cooperation and Development’s is 1.9 percent).

However, there are some headwinds:

• The cyclically adjusted P/E ratio (CAPE) for U.S. stocks is at 26.5, which is the highest since January 2008 (but lower than May 2007, which was 27.5). This CAPE is above its historical average of about 18, but we are hopeful that this is a signal that the market is optimistic of future earnings growth.
• IPOs are mixed: As of November 2, there were 95 IPOs raising $178 billion. The number of IPOs are down (150 in 2015 and 365 in 2014), but the amount raised is significantly higher ($28 billion in 2015 and $85 billion in 2014). The average first-day return was 14 percent, which is also down.
• The eurozone is more a source of risk than return: Supply-side barriers, such as labor market constraints, have been exacerbated by Brexit and may create a “secular stagnation,” which would impede an economic recovery.
• China’s growth is clearly slowing, and analysts are increasing skeptical about official numbers.
• Profit margins are declining: Firms must increase earnings by revenue growth, which is problematic given the weakness in Europe and China.
• The strong U.S. dollar is a headwind: The dollar has appreciated about 8 percent against the euro and 10 percent against the yen during 2016, despite continuing quantitative easing (QE). This will make U.S. exports more expensive in global markets while imports into the U.S. will become cheaper.
• U.S. debt: The expansion of the national debt since the end of 2008 is unprecedented since World War II. The total debt (held by the public) to GDP ratio has increased to 76.6 percent in 2016. Congressional Budget Office projections for 2017 have it around 80 percent of GDP under current policies. Trump does not have any feasible program to decrease it and probably will expand it dramatically (as would have Clinton). The massive government deficits may lead to fears of higher interest rates, accelerating inflation and slower growth.
• Budget deficits: The projected budget deficit for 2016 is about 3.2 percent of GDP. If interest rates return to their historical average levels, the budgetary impact will be dramatic. The average interest rate on debt held by the public is about 2 percent and interest payments are forecast to be $248 billion, rising to $300 billion in 2017 even if interest rates do not change. Increasing the average rate by 1 percent will trigger an additional $140 billion in federal spending. This will require reduced spending in other areas, increased taxes or both.
• The U.S. still faces a huge funding deficit in Social Security and Medicare payments. The present value shortfall is about $62 trillion. This is equivalent to $206,000 per person or $825,000 per U.S. household. These problems are not insurmountable, but they do require common sense and bipartisan leadership—something that appears to be in short supply in Washington, D.C.

Forecast

Looking forward to 2017, the positives outweigh the negatives for the economy, but just barely. We expect the recovery to continue, GDP growth in the 2-3 percent range and inflation around 2 percent. The combination of low inflation, a Fed that will cautiously return to normal interest rates, and decent prospects for earnings growth suggest at least a positive year for stocks. The primary risks are trade restrictions from Washington, economic policy uncertainty and the Fed.

In this environment, we expect the return on equities to be positive, but below the 7.5 percent average return over the past 50 years. With Treasury bonds already at extremely low yields, there is little potential for gains with these investments. In addition, we think there are material long-term inflation risks that could make long-term bonds unattractive. Investors should stick to short-term bonds to reduce their exposure to higher interest rates.